Introduction
Target date funds were introduced to provide the convenience of a single fund that automatically adjusted its asset allocation based on investors’ target retirement date. Today, more than $1 trillion is invested in these funds, making them one of the fastest growing and most popular types of mutual funds.
Target date funds provide investors with a diversified portfolio that automatically adjusts its mix of assets as the fund approaches its chosen target date. The goal is to give investors a simple way to invest in a professionally managed portfolio without having to worry about adjusting their asset allocation throughout retirement.
While they can be a useful tool, there are some things you need to know about target date funds before investing in one.
Target Date Funds are the usual go to option for most 401k Participants
Mutual fund companies and employers want to make investing easy for participants, so they created Target Date funds. With these portfolios, investors can choose a set of investments based on their age—they “set it and forget it.”
This target date fund approach gave investors a simple way to invest in a professionally managed portfolio without having to worry about adjusting their asset allocation throughout retirement. However, there are some drawbacks to Target Date Funds. They are not custom-made portfolios; they don’t fit all investors and they’re not always the best choice for your retirement portfolio.
Target Date Funds Manage Your Risk by a Process Called Glide Path
The glide path is the strategy used by a target date fund to change its asset allocation over time. A glide path is designed to reduce risk gradually over time as an investor ages and nears retirement. For example, as an investor gets closer to retirement, their portfolio automatically adjusts to a more conservative allocation.
The concept behind the glide path is that younger investors should have more equity in their portfolios because they have more years for their investments to compound and grow. As retirement approaches, however, the goal is to reduce investment risk, so that there isn’t much volatility in your portfolio when you need consistent returns.
Understanding the Risk of Target Date Funds
Although target-date funds aim to reduce risk as the target date approaches, they—like any investment—are not without risk. Target-date funds do not provide guaranteed income in retirement and can lose money if the stocks and bonds owned by the fund drop in value.
As Investopedia points out, not “all funds are created equal.” The underlying fund holdings and targets may differ from one product to another. For example, different target date mutual fund managers have different views regarding their asset allocation strategy. For example, the underlying holdings of a fund can change over time. It is difficult to know why one manager’s preference differs from other managers’.
The investment style of a target date fund may differ from other relevant target dates due to the actual makeup of its underlying holdings. These proportions will change over time as it matures toward its own stated goal (or “target”).
Last but not least, target date funds will have different expense ratios depending on what the fund company is investing in and which underlying stocks or funds are being used. The fact is, most target date funds are the same funds owned by the company—simply rebranded and packaged for marketing purposes. Instead of using a target date fund strategy, an asset allocation plan and strategy can be created to fit your unique risk and return profile.
The Myth of Time Diversification
Glide Paths have a glaring weakness according to investment academics: The Fallacy of Time Diversification. The belief that time diversifies risk is nonsensical and may be detrimental to investors’ ability to retire. People often assume that retirees face more risk than other age groups because of their dependence on investments for income. This is the driving principle behind Target Date Funds: As you near retirement, you’ll want to be reducing your exposure to risky assets and instead making smarter financial investments in safer assets.
Retirement Readiness and the Importance of a Financial Plan
Retirement readiness is a state of being financially prepared for retirement. Retirement is a time when individuals may be looking forward to spending their time doing what they enjoy and having more freedom. They might also be nervous about what changes retirement brings. A financial retirement plan can help you determine what your retirement goals are and whether or not the investments you’ve made will allow you to achieve those goals.
Conclusion
It’s important to be prepared for retirement. Whether you are just entering the workforce or nearing retirement, there might be a better “way” to invest when it comes to target date funds.
Investing involves three elements — diversification, asset allocation and targeting risk return dimensions— that work together to help you achieve your goals. Although target date funds attempt to provide diversification and asset allocation, they may not be the best way to target your risk-return goals.
If you want to take control of your retirement savings, a financial plan can help you determine what your retirement goals are and whether the investments you’ve made will allow you to achieve those goals.
